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Wage inflation

Robert Eisenbeis is CumberlandAdvisors' vice chairman and chief monetary economist. Prior to joining Cumberland,he was executive vice president and director of research at the Federal ReserveBank of Atlanta. He is a member of the U.S. Shadow Financial Regulatory Committeeand the Financial Economist Roundtable. Theviews and opinions expressed in this piece represent only those of the author andare not necessarily those of S&P Global Market Intelligence.

Wage inflation. Perhaps there is no term more frequently misusedby economic commentators and policy makers. We hear it constantly on Bloomberg andother media. Why do I say it's misused?  Inpart, the misunderstanding rests on a flawed story of the relationship between wagesand inflation.

The story is that, in the current economic environment, employmentcosts including wages are a substantial portion of overall business costs. So whenlabor markets are tight, employers bid up wages. Higher wages lower profit marginsthat are then passed on in the form of higher prices to customers. In other words,a low unemployment rate, which implies that labor is scarce, will ultimately causeprices to go up. The FOMC is banking on this dynamic, in part, to attain its 2%inflation objective.

This story is easily understood, and it implies that monitoringincreases in wages provides useful information about future inflation. But whatis the empirical evidence for this inflation story? A useful summary of currentresearch was provided recently by Rhys Bidder in the Nov. 2, 2015, EconomicLetters published by the Federal Reserve Bank of San Francisco. He examinedthe empirical studies that exhaustively explore the usefulness of movements in wagesas a barometer of inflation, including whether increases in wages lead measuresof inflation. The empirical work is quite clear on this subject: Movements in wagesoffer little information that can be used to predict inflation. Indeed, the evidencesuggests that increases in wages tend to lag increases in prices, not lead them.

But the issue is deeper than the simplistic idea that all increasesin wages should be called wage inflation. Wages can go up for two reasons, one goodand one not so good. If wages go up because labor has become more productive, thenworkers will be better off, and their purchasing power in real terms should increase.In such a case, an increase in wages is justified and will not be passed on to consumersand, thus, is not at all related to inflation. On the other hand, if wages go upbecause the price level in general has gone up, then, at best, real wages will beconstant, as will worker well-being. If prices go up faster than wages do, however,workers' living standards will decline in real terms. In that case, wages have goneup because of inflation, and workers are likely less well off than they were before.

In general, real wages — and hence workers' purchasing power— typically go up because of increases in productivity. Worker productivity cango up basically for three reasons. First, worker skills may have increased, boostingtheir productivity. Second, workers may have been provided with more capital, whichenhances their ability to produce. Third, combining capital and labor differentlyresults in what is called multifactor productivity. In simplistic terms, we cangive workers shovels, or we can provide them with one or more bulldozers.

In essence, this is what happened in the U.S. when farmers gaveup their horses for tractors. At the turn of the 20th century, it took one farmerto feed two people. Now, increased productivity enables a single farmer to feed50 people. Another example of changes in productivity is seen in history of theNew England textile industry, which moved first to the South and finally out ofthe country.

Before we wring our hands over those lost jobs, however, we mustrealize that the bulk of the job losses were in low-productivity jobs. I once hada former student pose the question: Would you want your daughter to sit behind oneof those sewing machines, or would you like to see her in some more productive,higher-paying job? Many of those lost jobs we simply don't want back because oftheir sweatshop nature.

Presently, it is a source of national economic concern that theeconomy has been mainly creating jobs that require only minimal skills and pay lowwages. If this trend means that workers are being underutilized because their inherentskills are greater than the skills needed to perform the job, then that's a problem.But we can't solve that problem by legislating increases in wages. We need to lookelsewhere — to changing incentives in the tax laws, promoting investment and reducingregulatory costs.

Recently, a movement to institute a so-called living wage hasgained traction in some parts of the country. The idea is that there is a minimumincome that the average worker needs to earn to be able to cover normal living expenses.Note that this view says nothing about worker productivity or whether workers arebeing compensated according to the value of their marginal product. Will laws likethose recently passed in California and New York make workers better or worse off?Conceptually, workers will be made better off if their present compensation is lessthan the value of their marginal product. If this is the case, then companies havebeen exploiting workers with low wages, and corporate profits are higher than canbe justified by the underlying economics of the firms involved and of labor markets.

However, if labor markets are reasonably competitive, then theincrease in wages will make it uneconomic for employers to maintain their presentworkforce. Employers will do one of several things: decrease their staffs, substitutecapital for labor to increase remaining worker productivity, move to another state,merge with larger firms to take advantage of potential scale and scope economies,or go out of business. These state-level experiments will help shed light on thetrue nature and sources of the perceived wage problem. Past experience suggests,however, that the young and first-time job seekers will be disadvantaged first.

The alternative to raising the minimum wage is, of course, tosupplement low-wage workers with assistance payments as a form of government safetynet. This, too, has obvious implications for state and local revenues and fiscalsituations.

But the bottom line is that we should stop using the vacuousterm wage inflation as if wage movements provided any useful information about inflationor workers' well-being.